Early Withdrawal From Retirement Plans: What You Need to Know Before You Cash Out

When money’s tight or life throws you a curveball, it’s tempting to dip into your retirement savings before age 59½. But before you request that distribution, it’s crucial to understand what qualifies as an “early withdrawal,” how much it might cost you in taxes and penalties, and the few exceptions that could save you thousands. 

What Counts as an Early Withdrawal? 

An early withdrawal simply means taking money from your retirement account before age 59½ — but the specific rules depend on the type of plan you have. 

There are two main categories of retirement accounts: 

• Qualified plans offered through employers, like 401(k)s and 403(b)s

• Individual retirement accounts (IRAs), which include traditional IRAs, SEP IRAs, SIMPLE IRAs, and Roth IRAs

While both types are designed to help you save for retirement, each follows slightly different rules when it comes to early distributions, penalties, and exceptions.

The 10% Early Withdrawal Penalty 

Generally, the IRS imposes a 10% penalty on early withdrawals in addition to regular income tax. That means if you withdraw $10,000 from your retirement account, you could owe a $1,000 penalty plus income tax on that distribution. 

When you take a distribution, your plan administrator will issue a tax form with a distribution code indicating whether an exception applies. If the plan is aware that your withdrawal qualifies for an exception, it will be coded appropriately — but it’s still your responsibility to make sure everything is reported correctly on your tax return. 

Common Exception to the Penalty 

Not all early withdrawals trigger the 10% penalty. Some situations qualify for exceptions — though the specific exceptions differ between qualified plans and IRAs. 

Here are a few of the most common: 

• Disability: if a doctor certifies that you’re totally and permanently disabled, your distribution may be penalty-free. 

• Death: If the account owner has passed away and you’re the beneficiary, you can generally withdraw funds without the 10% penalty. 

• Divorce settlement: Distributions made under a Qualified Domestic Relations Order (QDRO) as part of a divorce settlement are exempt from the penalty. 
  

There are also additional exceptions that apply only to IRAs, such as: 

• First-time home purchase: You can take a one-time distribution of up to $10,000 from an IRA to buy your first home without paying the penalty. (The purchase must occur within the same or following year of the withdrawal.) 

• Qualified higher education expenses or certain medical expenses: These may also qualify as exceptions under IRA rules. 

Because exceptions vary based on the type of account, it’s wise to consult with a tax professional before withdrawing funds to ensure you qualify. 

Understanding the Tax Impact 

Even if you qualify for an exemption to the 10% penalty, your early withdrawal is still subject to income tax. Most plans automatically withhold 20% for federal taxes, but that may not cover the full amount you owe — especially when you factor in the penalties and state taxes. 

For example, if you withdraw funds early, you might owe: 

• 20% withheld for federal income tax 

• 10% penalty for early withdrawal 

• 5% Indiana state income tax 
  

This adds up to roughly 35% of your withdrawal going towards taxes and penalties. When you file your return, the IRS will determine whether the amount withheld was enough, too much, or not enough — which could mean a refund, a balance due, or a break-even result. 

A common misconception is, “I already paid the tax on this.” In reality, you had tax withheld — but your final tax liability isn’t determined until you file your return. 

Plan Before You Pull 

Taking an early withdrawal from a retirement fund is a big financial decision — and one that comes with potential costs. Between the 10% penalty, federal and state income taxes, and the possibility of underpayment, the real amount you receive could be significantly less than you expect. 

Before you withdraw, review the possible exceptions, calculate the tax impact, and talk with a professional about your situation. We help clients understand how early distributions fit into their overall financial plan — and how to avoid costly surprises at tax time. 

Have questions about your specific situation? Reach out today, and we’ll walk through your options together!